Americans spend billions every year chasing deep discounts on retail products during Black Friday. Paradoxically, they do the exact opposite when assets go “on sale” during stock market crashes. Learn why this phenomenon exists and how to combat its effects by hacking your financial mindset.
‘Tis the Season
It never ceases to amaze me. The mad (sometimes violent) dash to stores. Friends and family bragging about who scored the better deal. Inboxes full of emails from brands hoping to convince you that you’re losing money if you don’t buy their products.
‘Tis the season. ladies and gentlemen. Welcome to the retail extravaganza we call Black Friday. Only in America could we manage to invent a holiday, the day after a holiday, to celebrate shopping for another holiday!
By no means am I here to tell you to skip Black Friday. Maybe you drew Aunt Kristie for Secret Santa. You know she won’t be satisfied with anything less than that Air Fryer. Might as well buy it for the best price possible. Just make sure you’ve planned for it. Holiday shopping isn’t spontaneous, after all.
Rather than denounce Black Friday, I want to use it as a vehicle to examine the psychology of money. Specifically, the way human instinct detrimentally impacts the behavior of both spenders and investors. Juxtaposing Black Friday excitement against the angst surrounding stock market crashes exposes some of the most glaring weaknesses in the way we make financial decisions. The goal of this post is to shed light on our financial biases and use this insight to make more rational financial choices in the future.
Black Friday Exuberance vs. Market Crash Anxiety
Americans spend billions every year chasing deep discounts on Black Friday. Often, it feels like we crave the excitement associated with securing great deals more than the products or services themselves. We then brag about these deals to friends with the goal of showcasing our consumer savviness.
Yet, when was the last time you heard someone brag about buying assets “on sale”? After the stock market crashes (and prices plummet to bargain levels) investors tend to run. Fast. We become paralyzed with fear. Or worse, we sell!
Given the fact that a properly diversified portfolio of index funds tends to rise significantly and predictably over a long horizon, this is quite irrational behavior. How can it be explained?
Well, perhaps we shouldn’t be so surprised. As behavioral economists Daniel Kahneman and Amos Tversky demonstrated in their groundbreaking work captured in Thinking, Fast and Slow, financial decisions are notoriously irrational.
Post Summary
For context, this post first summarizes Kahneman and Tversky’s most famous revelation: Prospect Theory. I’ll analyze two key tenets of this widely applicable theory using real-world examples to provide greater clarity.
Then, I’ll apply Prospect Theory to explain consumer behavior on Black Friday and investor behavior after the stock market crashes. In each of these instances, I’ll detail strategies I’ve personally used to combat the forces of Prospect Theory in my own life.
Ready for a nightmare flashback to Econ 101? Good.
Prospect Theory Overview
When Kahneman and Tversky originally published their 1979 work on Prospect Theory, it shook the world of academia to its core. Prospect Theory rejects the notion of “rational” behavior as it’s defined by classical economists. See, Kahneman and Tversky realized that outside of controlled laboratory-type settings, people tended to make choices that didn’t maximize personal welfare or utility.
The theory is multifaceted, with widespread applications and extensions. But at its core, Prospect Theory holds that individuals make economic decisions based upon relative circumstance, emotion, and somewhat arbitrary internal reference points.
Economists previously assumed that people made decisions based purely on their desire to maximize utility or economic benefit. This implied that when faced with multiple options, individuals would choose the one that optimized their expected value. Prospect Theory challenges this fundamental assumption. Instead, it asserts that humans consistently and predictably make choices that don’t maximize utility.
Let’s examine two key Prospect Theory principles below.
Loss Aversion
This aspect of the theory says humans asymmetrically evaluate tradeoffs depending on how they’re framed. The idea is epitomized by the saying: “losses loom larger than gains.” In other words, a loss causes more pain than the pleasure generated by a commensurate gain.
Probability Distortion
This concept states that people weight expected probabilities inaccurately when considering various outcomes. Individuals tend to assign greater weight to objectively low-probability outcomes (Ex: actual probability of 1% gets perceived probability of 10%). Conversely, less weight is given to objectively high-probability outcomes (Ex: actual probability of 99% gets perceived probability of 90%).
Prospect Theory Examples
I know this might all sound fancy and complex. You’re probably wondering why I’m boring you with an economics lesson. I promise, there’s a point to this.
The implications of Prospect Theory touch almost every financial decision that we make. Understanding the basics goes a long way. It’s worth investing the time to learn this now as it could radically alter your financial trajectory. Let’s further clarify things with a couple examples.
Prospect Theory Example #1 – Risk Aversion to Avoid Loss
Let’s say Bob attends a clown show this weekend. He’s sitting front row. When the clown’s assistant asks for audience volunteers, Bob excitedly jumps out of his seat. The assistant invites him onto the stage.
The clown places four red balls and one blue one underneath 5 overturned cups. He then shuffles the cups behind a curtain. Next, the clown hands Bob $75, explaining that he can take this money and sit back down. Alternatively, he can return the $75 and opt to play a game that gives him a chance to win more. The rules of the game are as follows:
- Choose one of the five randomly shuffled cups
- If Bob picks a cup with a red ball underneath, he wins $100
- If Bob picks the cup with a blue ball underneath, he gets nothing
Should Bob take the sure $75? Or should he play the game to chase the $100?
Prospect Theory’s Influence
Prospect Theory states that Bob will take the sure $75 over the chance to win $100. Some of you might already recognize this is a statistically suboptimal choice. Let’s look at the expected values of each decision:
- Four red balls in five total cups ( 4/5 = 80% chance of winning $100)
- One blue ball in five total cups (1/5 = 20% chance of winning $0)
- Expected value of the cup game = 0.80*$100 + 0.20*$0 = $80
- Expected value of not playing the cup game = 0.75*1.0 = $75
- $80 > $75
If all decisions were made from a purely rational perspective, people would always play this game. But that’s not what happens in reality. This demonstrates the power of Loss Aversion at work.
Since Bob can guarantee a $75 payday, he feels no need to press his statistical advantage to win more money. He evaluates risk in an “asymmetric” manner. The thought of walking away with nothing after holding $75 in his hands clouds his rational decision-making abilities. It’s an unpleasant enough idea that it convinces him to overlook expected value and cling to safety.
Loss Aversion with a Twist – Seeking Risk to Avoid Losses
Interestingly, Loss Aversion works in the opposite direction with negative outcomes. Pretend Bob had to choose between paying the clown a guaranteed $75 or playing the same game in reverse. In this reversed version, the game would provide an 80% chance of paying the clown $100 and 20% chance of paying the clown $0.
Under this scenario, Prospect Theory states that Bob would opt to play the game. Again, this represents the suboptimal decision from a mathematical perspective. The expected value of the guaranteed payment is -$75 versus -$80 if he plays the game. Yet faced with the choice between two negative outcomes, people prefer taking larger risks. The small chance of avoiding a loss becomes increasingly attractive since a sure loss feels so distasteful.
Prospect Theory Example #2 – Probability Distortion
Let’s now say Bob has a partial ownership stake in his friend’s company. If Bob decides to cash out of his position today, he will receive $100. Alternatively, Bob could remain involved for another month before exiting. He will receive $1,000 if he waits a month because the company will release its new product in that time.
But the company’s future looks uncertain. Assume Bob has access to perfect information. The probability that the company will succeed for another month is just 5%. The product development is well behind schedule. His friend is notoriously unreliable. Some hefty bills are due. There’s a 95% chance that the company fails and Bob makes nothing.
Should Bob take the immediate $100 payout? Or should he roll the dice, banking on a larger payout next month?
Prospect Theory’s Influence
Prospect Theory tells us Bob will tend gamble on the larger payout here. Again, this represents a suboptimal decision. Let’s look at the expected values like before:
- Expected value of holding for another month = 0.05*$1,000 + 0.95*$0 = $50
- Expected value of cashing out now = 1.0*$100 = $100
- $100 > $50
Bob could guarantee a $100 payment today and walk away. The $100 expected value of this decision is larger than the $50 expected value of holding for another month. But remember, people often overweight objectively low probability outcomes. Probability Distortion causes Bob to overestimate the likelihood that the company will succeed even though it seems destined to fail. He’ll likely opt to take the added risk in the hopes of a homerun return.
Prospect Theory and Black Friday Pandemonium
“If shopping on the other 364 days of the year is the behavioral economist’s version of bringing a knife to a gunfight, going out on Black Friday is going to that same gunfight with a knife made out of Play-Doh.”
Keven Roose
Black Friday is like a lethal cocktail, exposing every flaw embedded in the human monkey brain. Marketers adroitly exploit this, using some of the key tenets of Prospect Theory against shoppers. Kevin Roose offers some tremendous insight on the psychological strings that brand strategists tend to pull in the hopes of shaping consumer behavior.
The most pertinent Prospect Theory concept that gets exploited is Loss Aversion.
Think about Black Friday at a macro-level. It’s short window of time where consumers are encouraged to spend freely on deals that will be “gone in a flash.” Sellers tout limited inventory, doorbuster deals, and feed the media images of people physically fighting for the chance to secure the best sale.
It’s animalistic, instinctual, and all by design. I’d place a healthy wager on the fact that there are a handful of brilliant behavioral economists making a pretty penny teaching our favorite brands how to optimize their Black Friday campaigns.
Resetting the Consumer Reference Point
The true genius of Black Friday lies in the way it completely rearranges a consumer’s frame of reference. On any other day, a consumer might consider the choice of buying that new sweater versus the happiness or security provided by simply saving that $80 for the future. Keeping the $80 in savings represents the baseline case.
On Black Friday, retailers change the game. They shift the universe of choices within a consumer’s mind. The consumer no longer compares the utility of that sweater to the baseline utility of future money in an account. Instead, the consumer compares the price of the heavily discounted item to the price of that item under normal circumstances.
Notice what just happened? The baseline case shifted. Saving the money is no longer an option under consideration.
If the sweater costs $30 on Black Friday, but $80 normally, Prospect Theory slaps the consumer on the face! It tells them to buy now! The $50 savings gets perceived as a guaranteed win in the consumer’s mind. The thought of “losing” that perceived creation of value is excruciating.
Most of us can admit that there will always be a better deal in the future. Consumer preferences change, inventory piles up, stores close and liquidate their products, etc. Yet Prospect Theory blinds us to these rational thoughts. Just as Bob takes the $75 from the clown and runs, the Black Friday shopper opts for sure savings over a chance for better savings down the road.
And remember, these savings don’t actually represent a gain for the consumer at all. Whether paying full price or a promotional price, wealth is still transferred from shopper to retailer. The consumer’s wallet has thinned either way…just by varying orders of magnitude.
My Black Friday Strategy
There are a few key strategies that I employ to mitigate the effects of Prospect Theory on my shopping habits. Whether it’s Black Friday, Amazon Prime Day, or just an average Tuesday night, I’ve found the following tactics helpful.
Visualization
As stated, Black Friday’s power stems from the way it reframes an individual’s baseline case. Visualization can help to stop this phenomenon.
We took a detailed look at visualization tactics in a separate post on my Money Mercenary mindset. In summary, I give life to my assets and investments. I picture every dollar that I’ve ever invested into an asset as a warrior or “mercenary” enlisted in my financial military. I literally envision them waking up (before me), strapping on their armor, and going to battle to secure my future wealth.
With a strong visualization practice in place, Black Friday is less likely to reset your baseline. You’ll be less tempted to compare a product’s promotional price to its usual price. This allows you to remain more rational, comparing the notion of giving money to a retailer versus saving it for your future goals.
List Creation
When diving into Black Friday’s chaos, arm yourself with a carefully cultivated list of target items. Avoid the intoxication, emotion, and thrill of chasing a deal by adhering to this list rigidly.
It’s not inherently “bad” to shop on Black Friday. It can be one of the best times to find incredible deals. If you’re planning to buy the product anyway, it makes sense to snag it at the best price possible. But people run into trouble buying items they never would have otherwise desired. No discount justifies the purchase of something you don’t want or need.
A solid list builds structure into your Black Friday experience. It bounds your emotions and allow you to attack the best deals methodically. As a side benefit, it will also help you save an appropriate amount in advance.
Data Aggregation
In the digital era, shoppers have access to almost perfect pricing information. We’re bombarded with deals everyday in our inboxes. Comparison shopping for any item can be done with the click of a button. We can negotiate an in-store price match simply by pulling out a cell phone. Great deals abound all the time!
So in tandem with your list , chart price movements of your targeted big-ticket items over a few months. This will provide you with insight regarding the true value of a given discount.
A TV on sale for $800 with a crossed out $1,400 sticker might seem like a bargain. But if that TV routinely sells for $900 anyway, you’re saving much less than you think. So use data to your advantage. This will help you remain calm and build a framework for a successful Black Friday.
Prospect Theory and Stock Market Crashes
“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
Warren Buffet
As demonstrated by the Probability Distortion example above, people tend to overweight the odds that an unlikely outcome will occur. Conversely, individuals underweight the probability that a likely event will happen.
In an investing context, this means people are more likely to bet big on moonshot companies / projects with small chances of succeeding. They believe their bet is more likely to pay off than the objective statistical data would indicate.
Additionally, Prospect Theory holds that these same people fail to invest an adequate portion of their portfolio in “blue chip” performers with stable track records, and a high likelihood of consistent long-term returns.
In short, investors are likely to underperform the market left to their own devices. They have an irrational tendency to allocate too large a portion of their portfolios towards risky bets. And a similarly irrational tendency to allocate too small a portion to more diversified and stable stocks or funds. This is one investing conclusion that we can draw from Prospect Theory.
But this notion has been widely researched and discussed. Here, let’s focus specifically on how Prospect Theory seems to influence investor behavior following stock market crashes.
Stock Market Probabilities
Over the short term, the stock market can be a wildly unpredictable, scary beast. However, over a long enough time horizon, the volatility smooths. There are clearly discernable patterns.
From 1926-2019, the total annual return of the S&P has been negative just 25 times. While past performance is, of course, no guarantee of future results, this is a remarkable fact. This data implies that the market has a ~73% chance of yielding a positive return in a given year (which is why you can sleep your way to wealth).
This means that buying a total market index fund on virtually any day is the statistically optimal decision. And following a stock market crash, when everyone thinks the world is ending, the incentive to buy should grow even stronger. Just like that sweater on Black Friday, stocks are priced at basement-level bargains following stock market crashes. Unfortunately, many investors panic in this moment. This panic leads them to sell at precisely the moment when objective analysis would say it’s time to buy.
Loss Aversion and Probability Distortion Following Stock Market Crashes
Prospect Theory wreaks psychological havoc on multiples levels following stock market crashes.
First, Loss Aversion runs wild. Individuals with money sitting idly on the sidelines grow wary of deploying it into the market. Their reference point for wealth is the sum of cash that exists today in a bank account. The pain and fear associated with deploying this capital into a plummeting market trumps the psychological reward of investing for superior gains decades in the future.
Additionally, Probability Distortion exerts strong influence. Historical data indicates that the stock market will generate a positive return almost three out of every four years. But Prospect Theory states that many investors will underweight the likelihood that this high-probability outcome will occur.
These two psychological principles, combined with modern society’s obsession with doomsday media, make an investor’s job daunting during stock market crashes. An optimal response requires a vicious fight against mental predispositions that have been engrained by millions of evolutionary years. No small task. And yet, the rewards for doing so can be incredible. Just ask Buffet.
My Strategy for Stock Market Crashes
I don’t consider myself an exceptional investor or stock picker. I’m susceptible to the same emotional swings and shortcomings that most average investors face. As a result, I’ve applied the following strategies to help dummy-proof my investing process and avoid irrational decisions during chaotic moments.
Dollar Cost Averaging
This means investing fixed amounts of money into a diversified index fund at predetermined intervals. No matter what! It’s non-negotiable for me.
I don’t fully automate this process with a robo-advisor or automatic transfer because I like the sense of feeling in control of my money. But it might as well be on auto-pilot. I don’t deviate from the plan.
Dollar cost averaging systematizes what could otherwise be an emotional rollercoaster fraught with indecision. It allows me to block out any external factors and negative noise. It’s simply part of my weekly routine.
By investing a fixed dollar amount in each instance, more shares get purchased when the market’s “cheap” and less get purchased when it’s “expensive.” This system does the bargain hunting for you!
Mental Reflection
During market downturns and corrections, I find writing down my thoughts, emotions, and fears to be therapeutic. It allows me to drain my brain of all the negativity, speculation and uncertainty that swirls. While it doesn’t completely rid my mind of these feelings, it helps ease the burden.
Additionally, this serves as a useful record-keeping mechanism. The longer you invest, the more stock market crashes you’ll experience, and the more familiar you’ll become with your emotional response to these crashes. You’ll learn to anticipate your psychological reactions.
As investors, we fear the unknown. This written log helps to eliminate this uncertainty. Reviewing emotional responses to past downturns in conjunction with the market rebounds that followed will inspire increased confidence and comfort.
Cash Reserves
Maintaining a large cash cushion benefits me in two key ways during stock market crashes.
First, it provides me with peace of mind. In the event of a market crash and simultaneous professional hardship, I could survive off cash reserves for a significant period of time. I take comfort in this fact, and it helps me sleep better at night.
Additionally, my cash cushion allows me to act more opportunistically. While wealth is certainly destroyed by market crashes, it’s also made! A significant cash position enables me to capitalize by taking strategic risks at attractive discounts. The best time to run towards something is often when everyone else is running away.
Key Takeaways
It’s ironic, isn’t it? Black Friday and stock market crashes actually share lots in common. But Prospect Theory causes us to act oppositely and irrationally in both cases.
We can work to resist the influence of Prospect Theory, but it takes hard work. The first step is simply building awareness. Recognize the power of this theory. Acknowledge that we have psychological biases that often prevent us from making sound money choices.
In this post, I identified some of the key strategies that I use to counter Prospect Theory’s most detrimental effects. As always, these are just ideas and frameworks that work for me personally. Adapt and refine them. Experiment to find what works best for you.
If you take nothing else from this post, remember this: a stock market crash is like the Black Friday sale of a lifetime for your future wealth. Effectively, you’re buying net worth at a discount. While America might celebrate Black Friday once per year, you can celebrate whenever you want if you’re prepared to embrace opportunity when others waver.